cf analysis2

8/12/2019 CF Analysis2

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Managing Working Capital

The job of the cash manager is minimizing working capital while maintaining adequate liquidity.In the simplest of terms it is to accelerate cash receipts and delay cash disbursements. The cashmanager has a variety of internal and external tools available to accomplish this. Internal tools

include policies, procedures, administrative practices and terms of trade. External tools includeproducts offered by third parties.

The internal tools apply to the areas of purchasing, receiving, inventory management, accountsreceivable and accounts payable. Many of the internal tools discussed here are administrativeprocesses or procedures that simplify, control and create efficiency. Many of these tools are notpractical in a small private company however the discipline of following the general rules will beof increasing benefit as the company grows in size and scope. It is therefore recommended thatowners and managers be aware of these tools and apply them whenever the opportunities arise.

Administrative tools

Owners and cash managers can reduce administrative costs by centralize purchasing for the firmor at least within major business units. Standardize purchasing policies and procedures helpprevent duplicate purchase orders. Purchase order forms should be standardized. Copies of allpurchase orders should be forwarded to Accounts Payable and Receiving immediately uponcreation. When negotiating with vendors the cash manager should first negotiate price, thenterms. The purchasing department should coordinate with accounts payable to maximizeleverage on vendor.

Supply disruptions must be prevented because they can bring sales and cash flow to a halt.Companies should use multiple suppliers when possible. Cash managers should know thesuppliers financial condition so they can anticipate potential disruptions due to financial stress.Signs of supplier financial trouble include calls to the supplier not being returned, consistentorder errors or deterioration in quality of merchandise, late delivery of merchandise and supplieremployees inquiring about job openings.

Cash managers can enhance cash flow by taking simple steps in the Receiving department.Receiving should already have a copy of the purchase order at time goods are received. Stepsshould be taken to minimize paperwork errors in the receiving department. All goods should beexamined immediately upon arrival and checked against the purchase order. Received goodsshould immediately be committed to inventory and entered into accounting system. Shippingdocuments should be forwarded to Accounts Payable immediately upon receipt and inspection ofthe goods.

In managing accounts receivable centralize collection efforts within the firm or at least withinmajor business units. This means employing a dedicated collection staff. Have the staff callcustomers frequently to inquire about payment if the payment is late. The customer will not beoffended if it is already late. Process all customer remittances immediately dont allow them tobe put into a drawer until the next day. Deposit collections daily if not using a lock box.


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Make it easy for the customer to pay. Provide return envelopes with invoices. Get customerauthorization to make automatic debits. Make arrangements to accept wire transfers, credit cardpayments and depository transfer checks.

A/P processing should be centralized for the firm or at least within major business units. Policies

and procedures for handling A/P should be standardized across the company. These policies andprocedures should prevent overpayments, duplicate payments or payments to fictitious vendors.

Vendor invoices should be processed immediately upon receipt. They should be compared withthe shipping documents and original purchase orders to ensure that amounts being billed areconsistent with the goods ordered and received. Only then should they be entered into the A/Psystem. Avoid rush checks because they disrupt work flow and are the leading cause of duplicatepayments. Coordinate A/P with purchasing to maximize leverage on vendor. A prompt paymentcan sometimes win a better price or discount.

Inventory tools

There are a number of things an owner or cash manager can do to reduce the cost of carryinginventory and turn it into cash more quickly. Some of these things are simple and work in anysize business. Other things are more appropriate for larger or businesses with greater structureand resources. Business owners and cash managers should be aware of all of them.

The easiest thing to do is to turn stale or slow moving inventory into cash. This can be done bydiscounting inventory to move quickly, having a warehouse sale or returning the inventory to thevendor. Simply writing down impaired inventory can save cash even if it is not sold because abook loss is created that will reduce income taxes now or in the future.

In todays electronic environment almost all companies that stock goods can benefit from the useof just-in-time inventory systems. Whether we it is ordering finished product ready for sale orcomponents used in a manufacturing process, such systems can free up cash that otherwisewould be tied up in inventory. The benefits of using such a system include:

1. Reduced inventory levels and increases turnover;2. Reduced purchasing lead time and safety stocks;3. Increased scheduling flexibility;4. Lower investment in factory and warehouse space;5. Reduced obsolescence;6. Reduced scrap and rework; and7. Reduced operating expense.

Potential negatives of using such systems include:

1. Order lead times require accurate planning2. Changes in amounts and dates disrupt suppliers plans and create additional costs3. Poor planning can result in inventory overages or shortages

a. Overages tie up cashb. Shortages reduce sales, profits and cash flow


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Companies that manufacture the products that they sell should consider buying vs. building. Theadvantages include a reduced investment in inventory, the elimination of manufacturing costsand overhead and potentially a lower cost of goods sold. The disadvantages outsourcingmanufacturing include: a) Advanced deposit or letter of credit requirements; b) Potential delivery

delays that can costs sales, profit and cash flow; and c) Potential product errors or poor qualitythat can create returns and customer dissatisfaction. Companies that outsource theirmanufacturing often can also use Electronic Data Interchange (EDI) to reduce inventoryrequirements. EDI accelerates ordering and shipping because suppliers have access to inventoryledger. Suppliers are pre-authorized to ship specified quantities when inventory declines tospecified level. Invoicing is done electronically.

Inventory management should involve an analysis of Economic Order Quantity (EOQ). In smallcompanies the business owner can do this with an Excel spreadsheet. Larger companies requirecomplex inventory management systems. Ordering inventory (or supplies for that matter) costsmoney in terms of purchasing, shipping & handling, receiving, accounting and related

operational costs. Carrying costs include housing, handling, insurance, shrinkage, recordkeeping, cost of invested capital and related operational costs. The theory behind EOQ is thatordering costs are inversely related to carrying costs. Small, frequent orders increase orderingcosts but reduce carrying costs. Large, infrequent orders minimize ordering costs but increasecarrying costs. EOQ analyzes the cost of ordering inventory versus the cost of carrying inventoryin an effort to determine the optimal amount and frequency of ordering. EOQ will be discussedin more detail in a future article discussing modeling.

Few things increase the cost of inventory and the use of related cash like defective products.Defects cause waste, inefficiency and rework. They cause companies to reduce order quantitiesand order more frequently thereby increasing costs. Defective production can sometimes beminimized by using one or two high quality suppliers for each inventory item. Fewer suppliersreduce ordering costs resulting in fewer orders and increased Economic Order Quantities. Totalorder and inventory carry costs decline.

Effective inventory management is essential to any company seeking optimal utilization of itscash resources. It is particularly important in small companies which are cash constrained andhigh growth companies that need to maximize the internal generation of cash resources to fundgrowth.

Accounts receivable toolsThere are a number of things an owner or cash manager can do to reduce the cost of carryingaccounts receivable and turn it into cash more quickly. Some of these things are simple and workin any size business. Other things are more appropriate for larger or businesses with greaterstructure and resources. Business owners and cash managers should be aware of all of them.

Credit check each new customer and credit check all customers at least once each year. Monitornon-payment aggressively and dont be afraid to cut a customer off for non-payment. Calldelinquent customers daily and do not be afraid to use COD terms.


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Offering discounts to customers for early payment is a very effective way to accelerate cashreceipts but it can be expensive. The key is to calculate the appropriate discount to offer. Theannualized cost of the discount should be less than the companys incremental cost of capital.The formula to determine true cost of a discount is:

(Percent discount x 365)/days gained in cash receipt

Therefore, if the terms are 2% 10, net 30 then:

.02 x 365/20 = 7.3/20 = 36.5%

In this case if the companys incremental cost of capital exceeds 36.5% then the discount shouldbe offered. As the table below shows, offering an enticing discount to pay within 30 days isclearly expensive. It is therefore critical that customers be prevented from taking the discountafter the early pay date.

A preferable alternative to accelerate cash flow may be to borrow against the accounts receivableunder a working capital line of credit. For most companies this would cost less than 36.5% perannum. However, many companies do not have access to a line of credit and even some that dowould prefer to offer the discount and preserve availability under the line of credit for inventoryfinancing or unexpected working capital requirements.

Cash management services are generally provided by banks as a means of accelerating the

collection, deposit and investment of your funds. These services generally consist of lock boxes,operating accounts, sweep accounts, on-line reporting and investment services. More recentlybanks are offering in-house check scanning and on-line deposit services as an alternative to lockboxes. Lock boxes and in-house check scanning accelerate the deposit and availability ofcustomer payments. Every night deposits in excess of a pre-determined minimum balance areswept into a sweep account for overnight investment. Earnings on the invested funds are thenapplied to the cost of other services provided by the bank (item charges, wire transfers, stop


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payments, etc.). This minimizes excess cash balances and maximizes investment income. On-line information systems give the owner or cash manager access to daily activity.

Effective accounts receivable management is essential to any company seeking optimalutilization of its cash resources. It is particularly important in small companies which are cash

constrained and high growth companies that need to maximize the internal generation of cashresources to fund growth.

Accounts payable and working capital credit linesThe effective management of Accounts Payable and credit lines by an owner or cash managercan greatly enhance cash flow. Some things are simple and work in any size business. Otherthings are more appropriate for larger or businesses with greater structure and resources.Business owners and cash managers should be aware of all of them.

Issue checks from small banks, thrifts or credit unions in remote locations to improve mail andclearing float. With electronic clearing this is now less important but it could help to pick up one

or two days additional float.

Take discounts when available if the incremental cost of capital is less than the annualized yieldequivalent of the discount. Remember, a 2% discount taken 20 days before the payment is dueequals a 36.5% annualized yield. A 1% discount taken 20 days before the payment is due equalsan 18% annualized yield. The chart below provides the annual percentage yield on variousdiscounts taken.

Used properly working capital lines of credit are an important tool for maximizing cash flow.They provide cash to finance seasonal increases in inventory and accounts receivable. Duringthese periods the cash helps to keep vendors happy thereby maintaining favorable relationshipsand credit ratings. In essence, credit lines turn inventory and accounts receivable into cash beforethe completion of the cash cycle.


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Working capital credit lines are obtained from banks and asset based lenders. Banks are insureddepository institutions and their business is highly regulated. As a result they have higher creditstandards and their loan agreements usually come with more restrictive covenants andconditions. Asset based lenders do not take deposits and are not regulated to the extent banks are.This enables them to make loans that banks may not be willing or able to make. As a result loans

from asset based lenders usually carry a higher interest rate.

Banks and asset based lenders both advance funds against a formula equaling a percentage ofaccounts receivable and inventory. Banks look to cash flow as their primary source of repaymentand because they view these lines of credit as seasonal they expect they will be paid off at leastonce a year. Asset based lenders generally look to the assets as the primary source of repaymentand so long as they are comfortable with the quality of the assets they generally dont require anannual cleanup.

Because both types of lenders ultimately look to the assets, working capital lines of credit arealmost always done on a secured basis. A security interest is taken in the accounts receivable and

inventory, and in many cases the borrower is required to pledge all of its assets. From anoperational standpoint the main difference between the two lenders is the amount of reportingrequired. Because asset based lenders are primarily looking at the value of the assets as theirsource of repayment they require much more frequent and detailed reporting. They take controlof all receipts and deposit them into an account they control. Surplus cash is used to pay downthe credit line. When the company needs cash it must apply for a new advance and submit therequired supporting documentation. If the advance is made it is then deposited by the lender intothe companys operating account.

Because working with an asset based lender is so much more operationally intensive the addedadministrative expense makes borrowing even more expensive. It is therefore worthwhile to shoparound extensively for a bank credit line before accepting one from an asset based lender.

Effective utilization of working capital lines of credit is essential to any company seeking tomaximize cash flow. It is particularly important in small companies which are cash constrainedand high growth companies that need to ensure that cash resources are continually available tofund growth.


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Inventory Models

Inventory modeling as a way to manage and enhance cash flow can be useful in both small andlarge companies. In small companies the business owner can do some of the less complexmodeling with an Excel spreadsheet. Larger companies require complex inventory systems.

Irrespective of the size of the company business owners and cash managers should know howmodels can be used to predict the optimal amount of inventory on hand to maximize cash flowand minimize interest expense. The most common models are the Reorder Point, InventoryOptimization and Economic Order Quantity (EOQ) models.

Reorder Point Model (ROP)

Reorder point is a predetermined amount of inventory on hand that when reached automaticallytriggers an order for more inventory in a fixed amount. To use this model a business owner orcash manager must be able to accurately predict the lead time between order and merchandisereceipt. The reorder point is computed as follows:

ROP = lead time x average usage per unit of time (week, month, etc.)

This formula indicates the inventory level at which a new order should be placed. If a safetystock is required it should be added to ROP after the calculation is made.

Example

A company uses 20,000 pieces of inventory evenly throughout the year. It takes one month fromthe time an order is placed to receive the goods. Management wants to keep a buffer stock of 500units on hand. The reorder point is:

ROP = 1 x (20,000/12) + 500= 1 x 1,667 + 500= 2,167 units

When the inventory level falls to 2,167 units a new order should be placed for 1,667 units.

Inventory Optimization

Often a company can increase sales by increasing the amount of inventory on hand. This isusually when the inventory increase will reduce back-orders and increase deliveries. This is theopportunity cost of not carrying sufficient inventory. Of course keeping additional inventory onhand increases carrying costs so the object of the exercise is to determine the optimal amount ofinventory that will result in the greatest incremental income at the least increase in carrying cost.To make this determination a manager must be able to estimate the increase in sales volumeresulting from an increase in inventory, know the companys variable costs as a percent of sales,and know the financing costs associated with the increased inventory. The formula would be:

(S x (1-C)) (I x i) = N

Where: S = increase in sales resulting from the increase in inventoryC = variable costs as a percent of sales


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I = increase in the value of inventoryi = financing cost of inventory (usually interest on short term borrowing)

N = Net Savings

Example

A company has average inventory of $75,000 and annual sales of $900,000. Managementbelieves that increasing inventory would result in increased sales up to a point as back orders getfilled and deliveries increase. Following the laws of diminishing returns estimates are thatinventory increases would produce the following sales results:

I Inventory Sales Turnover$0.00 $75,000 $900,000 12.0

$10,000 $85,000 $1,000,000 11.8$10,000 $95,000 $1,040,000 10.9$10,000 $105,000 $1,070,000 10.2$10,000 $115,000 $1,090,000 9.5

The companys variable cost as a percent of sales is 60% and its interest expense on short termborrowings is 12%. Determine the optimal amount of inventory to carry.

S I (S x (1-C)) (I x i) N$0.00 $0.00 $0.00 $0.00 $0.00

$100,000 $10,000 $40,000 $1,200 $38,800$40,000 $10,000 $16,000 $1,200 $14,800$30,000 $10,000 $12,000 $1,200 $10,800$20,000 $10,000 $8,000 $1,200 $6,800

The optimal amount of inventory to carry is $85,000 because the $10,000 increase from currentlevels produces the greatest net savings.

Economic Order Quantity (EOQ)EOQ attempts to determine the amount of inventory to purchase with each order to minimizetotal inventory cost. Ordering inventory costs money in terms of purchasing, shipping &handling, receiving, accounting and related operational expense. Carrying costs include housing,handling, insurance, shrinkage, record keeping, cost of invested capital and related operationalcosts. The theory behind EOQ is that ordering costs are inversely related to carrying costs. Small,frequent orders increase ordering costs but reduce carrying costs. Large, infrequent ordersminimize ordering costs but increase carrying costs. EOQ analyzes the cost of ordering inventory

versus the cost of carrying inventory in an effort to determine the optimal amount and frequencyof ordering. In graphic form the optimal Economic Order Quantity is where the cost of orderingline intersects the cost of carrying line as depicted below.


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The EOQ formula is:

2SO/C

Where: S = annual usage of inventoryO = ordering cost per orderC = carrying cost per unit per year.

The number of orders per year formula is:

S/EOQ

Order frequency in days can be determined by the formula:

360/orders per year

In a perfect world orders would be placed at regular intervals in amounts as determined by theabove formula. This would result in a least cost average inventory level with minimized orderingcosts as graphically depicted below.


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But the world is not perfect or predictable so many companies choose to maintain a safety stockof inventory to absorb any unexpected usage or delays in inventory shipments. The impact ofsafety stocks and irregular usage can be depicted in the following graph. In the first inventorycycle inventory usage suddenly increases thereby depleting the safety stock. Depletion of thesafety stock causes acceleration of the next order. In the fourth inventory cycle goods arrive latewhich again causes usage of the safety stock. This again causes acceleration of the next order.

EOQ is a necessary precursor to a JIT inventory system. However it does have its limitations,chief among them being that it can model only one type of inventory at a time and assumes thatthe item arrives and is used on a uniform and predictable basis throughout the year. It alsoassumes that revenues are not dependent on the level of inventory maintained (i.e. moreinventory equates to more sales), and that no discounts are taken for quantity purchases. Still,even with these limitations EOQ is a useful tool. Lets use an example.


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= 2,646/2= 1,323 units

Using this model and extrapolating the economies of scale out to infinity it can be seen that thetheoretical inventory level using a just-in-time inventory system is zero.

Building off of inventory models are cash models. Like inventory there is an economic cost ofmaintaining too much cash, too little cash and frequent investment transactions (buying andselling cash to meet cash needs). Cash models will be discussed in the next section.


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Cash Models

Modeling can also be useful in predicting the optimal amount of cash on hand to maximize cashflow and minimize interest expense. The most common models are the Baumol cash model andMiller-Orr cash model.

Baumol ModelDeveloped by William Baumol it is a derivative of the EOQ model. It is used to determine theoptimal amount of cash to hold in a predictable environment. It treats cash as inventory andbuying and selling investment transactions as ordering costs. The objective is to minimize thefixed cost of buying and selling investment transactions and minimize the opportunity cost ofholding too much cash. Just like in EOQ Baumol is a two-step formula. Step one is to determinethe optimal transaction size. Step two is to determine the optimal number of transactions in aperiod. Average cash holdings would be one half of the optimal transaction size.

Baumol formula is same as the EOQ formula except transaction cost is substituted for order cost

and interest cost is substituted for carry cost. The formula is:

Z = 2NF / i

Where:

Z = the zero point to which the cash balance returns (the EOQ)N = the annual cash need (the usage rate, S)F = the fixed cost of each cash-securities transaction (the order cost, O)i = the annual interest rate on marketable securities

The Baumol model can be depicted by the graph on the following page. The amount of cash tobe held is that point where the combined cost of cash transactions and the opportunity cost ofholding cash are the least.


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As with the EOQ model, the average amount of cash to be held and the frequency of securitiestransactions can be depicted in a graph as shown below. Should the company have an unexpectedneed for cash it will have to sell securities to raise cash earlier than it anticipated. An exampleshows how the formula works.

Example

A company has $5,000,000 per year in total cash disbursements. It costs $75 on average everytime securities are sold for cash. Calculate the Zero point, the number of transfers each year, thefrequency of transfers and the average cash holdings, if the current short term investment rate is5%.

Zero point = Z = 2NF / I = 2 x 5,000,000 x 75 / .05 = 15,000,000 = $38,730 (max cash)Number of transfers per year = N/Z = 5,000,000 / 38,730 = 129 transfersTransfer frequency = 360/number of transfers = 360 / 129 = 2.8 daysAverage cash balance = Z/2 = 38,730 / 2 = $19,365

In this case the company would replenish cash from securities approximately once every 3 dayswith each transaction being $38,730.

Baumol represents a good first try to the cash holdings problem. It is easy to use and understand.It is useful when cash in and out is constant and predictable. But it suffers from some

shortcomings. It relies on a constant cash flow which is unrealistic. It ignores the possibility ofaccumulating excess cash. Transaction costs are not always fixed.

Miller-Orr ModelThis model seeks to overcome the shortcomings of the Baumol model. It determines the optimalamount of cash to hold in an unpredictable environment. It extends the Baumol model in that ittracks both inflows and outflows of cash, allows inflows and outflows on an irregular and


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unpredictable basis and establishes two trigger points - the lower cash level at which securitiesmust be sold to replenish cash and the upper cash level at which surplus cash should be invested.

Miller-Orr is not concerned with the frequency of the securities transactions. It is trying todetermine the optimal time to buy or sell securities based on the amount of cash on hand. Miller-

Orr takes into consideration the fixed cost of securities transactions and assumes these costs arethe same when both buying and selling, the daily interest rate on marketable securities and thevariance of the daily net cash flows. The formula is:

Z = 33F2/4i +LCL

Where:

Z = Zero Point the cash balance return pointF = Fixed cost of each securities transactioni = Interest rateper dayon marketable securities2

= Statistical variability of the net daily cash flowLCL = Lower cash limit (established by management)

The upper cash limit, or UCL, is established by the formula

UCL = 3Z 2(LCL)

The average cash balance is established by the formula

(4Z LCL) / 3

The Miller-Orr model can be depicted by the following graph:

Example


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A company has $5,000,000 per year in total cash disbursements. It costs $75 on average everytime securities are sold for cash. The cash manager estimates that the variance of change in thedaily cash flow balance is $200,000. He also establishes that the lower cash limit is $5,000.Calculate the Zero point, the upper cash limit and the average cash balance if the current shortterm investment rate is 5%.

Answer:I = .05/365

= .000137

LCL = $5,000

Z = 33F2/4i + LCL= 3(3 x 75 x 2,000,000) / (4 x.000137) + 5,000= 3(8.21168E+15) + 5,000= 20,175 + 5,000

= $25,175

UCL = 3Z (2 x 5,000)= 75,525 10,000= $65,525

Average cash balance = (4Z 5,000) / 3= 95,700 / 3= $31,900

The upper cash limit, or that point where the company buys securities with cash over and abovethat amount, is $65,525. The lower cash limit set by management is $5,000 at which point thecompany sells securities to raise cash. The average cash balance is $31,900.

Effective modeling is not essential to any company seeking optimal utilization of its cashresources but it can help if used properly. It is particularly useful to large and rapidly growingcompanies that have complex cash management requirements. It can also be useful to smallcompanies which are cash constrained. However business owners must be careful not to losetouch with actual day to day cash flow challenges for the sake of modeling. One could modeloneself right out of business.


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Multinational and Resource Based Companies

Cash management in a multinational company presents its own special challenges. Cashmanagers must deal with multiple currencies, country risk, inflation disparities, local versusparent control, multiple financing options, multiple tax codes, multiple regulatory environments,

remittance decisions, currency and capital controls and transfer pricing considerations.Multinational resource based companies have even greater special challenges. Below are some ofthe considerations for cash managers in multinational organizations.

Exchange rateExchange rate fluctuations greatly affect cash flow and therefore investment returns. If a localcurrency declines against the value of the home currency the value of any local currencyinvestments and cash flow generated by such investments declines in terms of the homecurrency. If the cash flow declines in value then the return on investment also declines.Exchange rates are influenced by economic, inflation and interest rate disparities betweenindustrialized countries. They are generally most stable between industrialized countries and

newly industrialized countries. Exchange rates are often difficult to determine and are sometimesarbitrary in underdeveloped countries. Another issue affecting exchange rates is convertibilityand capital controls. Prior to making investment decisions cash managers should determine if thelocal currency is convertible and at what rate. Cash managers must also know prior to making aninvestment decision if local capital controls permit the remittance of capital out of the countryand if so what the tax consequences might be.

Country riskCountry risk should also be considered by the cash manager before making investment decisions.Such considerations would include the liquidity of capital markets, legal, institutional, socialconstraints, economic constraints, corruption and the prospect of government interference orexpropriation. Inflation disparities should also be considered. Inflation can be volatile inunderdeveloped countries and can even be volatile in industrialized countries. Cash managersmust also understand the limitations, if any, of parent company control of local companyoperations.

Financing decisionsIn a multinational environment financing decisions are complex. Does it make more sense toborrow locally or at the parent level? What about using an offshore financing vehicle? What isthe near term and long term outlook for the local currency given current economic outlook andinflation differentials? If the foreign assets are denominated in a foreign currency does it makesense for the liabilities to be denominated in the parent or other currency? The cash managermust answer all of these questions.

Tax considerationsThese are critically important to cash management in the multinational company. Such issues ashome country versus local country tax differentials must be analyzed. The tax treatment ofearnings repatriation must be understood at both the local and parent level. Is tax treatmentgoverned by treaty between the parent company government and the local company government?Tax treaties are common among developed countries but are unusual between developed and


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underdeveloped countries. They are rare between underdeveloped countries. When treaties donot exist they generally call for local companies to be taxed on worldwide accrued income andforeign companies to be taxed on local accrued income. Without tax treaties there is a possibilityof double taxation tax by both the parent and local governments on local income. The timing oftax payments also greatly impact cash flow. The cash manager must understand if local taxes are

paid upon accrual, upon remittance to the home country or upon exit from the investment. Thecash manager also must know if the payments are due monthly, quarterly or annually.

Remittance of profitThis is a big issue for the cash manager to consider. Where is the cash needed and when? Whatare tax consequences of remittances both locally and at the parent company level? What are therisks of retaining cash in foreign country? Do capital controls prevent the remittance of profits?

Transfer pricingIn a multinational company transfer pricing has big implications for the cash manager.Significant amounts of cash can be moved between parent and local companies through the

transfer pricing mechanism. Likewise, transfer pricing can be used as a tool to minimize taxes inthe higher tax jurisdiction. In determining transfer pricing the cash manager should considerwhere cash is needed, where it should be allowed to accumulate and the respective profits taxrate in the parent and local countries.

Resource based companiesThere are special cash management issues for the cash manager in resource based companies toconsider. Their product is a commodity priced in US dollars and subject to extreme pricevolatility. There is a futures market for the commodity which enables the implementation ofhedging strategies to make cash flow more predictable. But hedging requires taking futurepositions that may or may not turn out to be true.

Resource based companies generally engage in production, refining and distribution. Often thecommodity is produced in one country, refined in another and sometimes distributed in a third.The production expenses are paid in local currency, the commodity is purchased with US dollars,transportation expenses are paid in US dollars or another hard currency depending on thetransporter and refining and distribution expense is incurred in the local currency.

Commodity transportation poses additional issues. Transportation time creates additional risks.Commodity prices and exchange rates can change during transportation. This created additionalhedging requirements. In addition to all the other factors a cash manager must consider, theeconomics and logistics of the resource based company place demands on the job that areextraordinary. They generally can be handled by only the most experience cash managers withaccess to the most sophisticated cash management tools.

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